Basis Issues for Partnerships and S Corporations

Edward K. Zollars, CPA

www.cperesources.com

ed@tzlcpas.com

Importance of Basis

•One of three limits on deducting a loss•Required attachment to tax return for an S corporation shareholder claiming a loss•Must know basis to determine if•Distribution is taxable (Partnership or S

corporation)•Repayment of debt taxable (S corporation)

•Used to compute gain/loss on disposition of asset

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Must Have Basis to Prepare a Return for a Holder of a Flowthrough Entity

Basis and Debt - PartnershipsBasis Issues for Partnerships and S Corporations

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Partnerships and Debt

•Partnerships get basis from any debt

•Note that may not get at-risk amount (which is a different issue)

•Debt is responsible for what is often erroneously called “negative basis”

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Basis cannot go below zero

Basis is Not…

•A partner’s tax basis capital account

•A partner’s §704(b) capital account (“book” capital)

•A partner’s GAAP capital account

•The total of the partner’s share of the basis of partnership assets

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Definition of a Liability

•Per Reg. §1.752-1(a)(4) a liability•Creates or increases basis of an asset•Creates a deductible expense•Creates a nondeductible expense

•Special contingent liability ant-abuse rule –specifically blocks “Son of BOSS” structure

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All Partnership Liabilities are Classified as Either “Recourse” or “Nonrecourse”

Allocate Recourse Debts

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Presumption of Repayment

•All partners are presumed to meet their legal responsibilities to repay• Limited exception for disregarded entities

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Guarantees Don’t Change This Unless Partner Gives Up Right of Reimbursement

Distribution Problem

•Reduction in debt allocated to a partner is deemed to be a distribution of cash [IRC §752(b)]

•Distributions in excess of basis trigger taxable gain to partner [IRC §731(a)(1)]

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Nonrecourse Liabilities

•Only classified as such if no partner has economic risk of loss

•Note – this definition is not the definition used for testing cancellation of debt•Debt can be nonrecourse partnership debt•Still can be “recourse” for COD purposes•The simplest example would be accounts payable

in an LLC

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Allocation of Nonrecourse Debt

1st Tier

• Partner’s share of minimum gain on assets encumbered by nonrecourse debt

2nd Tier

• Partner’s share of minimum gain determined under §704(c)

3rd Tier

• Remainder using a reasonable method (generally profit sharing is reasonable)

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At-Risk is Separate from Basis

Basics of At Risk (Outside Manual)

•Losses may only be deducted to extent taxpayer is “at risk”•If amount at risk is reduced, must recapture prior losses claimed•Generally not at risk for nonrecourse debt•Certain real estate loans can be qualified nonrecourse debt•Compute on Form 6198

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Key Rules

•Your software cannot properly handle the allocation of debt to the partners except in trivial situations

•Many K-1s you receive will not be prepared correctly

•Must track debt from year to year for partner

•Remember the “cash distribution” problem

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Basis in Stock and Debt –S CorporationsBasis Issues for Partnerships and S Corporations

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S Corporations and Basis

•Different from partnerships in a number of ways

•Have stock basis and debt basis determined under different rules

•Debt basis is totally unrelated to partnership debt basis rules

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S Corporation Annual Basis Adjustments

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Basis Can Only Be Increased if Shareholder Actually Reports Income (But Reduction for Loss Takes Effect Regardless)

Special Rules

•Inherited stock & IRD issues

•Separate share rule

•Duty of consistency

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Debt Basis

•Once stock basis is exhausted move on to amounts loaned from shareholder to corporation

•Proportionate allocation to each debt

•Basis restored with income, and takes place•Before repayment gain/loss calculated•Before adjusting stock basis

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Debts That Provide Basis

•Must be “bona fide” debts

•Must be from shareholder •Can be borrowed from third party then lent •Shareholder must be only person on debt

•What does not work•Guarantee of debt•Co-maker

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Repayment of Debt

•If basis < face, a prorate amount of basis allocated to principal paid and taxpayer recognizes gain

•If no note – ordinary gain

•If evidenced by a note – capital gain

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Debt can be converted tax free to stock at any time – and why you might want to (or not want to) advise doing that

Carryovers and Basis Adjustments

•Additions first, then distributions

•Losses in excess of basis cannot be deducted

•Election to reorder basis adjustments• If don’t make election, must first reduce basis (but

not below zero) by nondeductible items• If still have nondeductible items, they disappear• If elect, nondeductibles pushed to last item to be

used but must be carried forward

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Schedule E Instructions Require Basis Schedule When S Losses Claimed

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If stock is sold, first make basis adjustments, then compute gain/loss on sale

Partnership Basis Adjustments(§704(c) and §754)Basis Issues for Partnerships and S Corporations

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Section 704(c)

•Built-in gains/losses go to contributing partner

•Also appears when have recapitalizations (reverse 704(c) allocations)

•Different than S result

•Must be used unless de minimis rule applies•Difference not more than 15% and•Total difference not more than $20,000

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Traditional Method

•Only use actual items to allocate differences

•May end up not “solving” the problem entirely due to ceiling rule

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Traditional Method with Curative Allocations

•Can use other “similar” items actually on the return to fix the original differences

•For instance, ordinary business deductions could “substitute” for depreciation

•Much more likely to solve problem

•However still possible to end up with no way to solve or nothing “similar” exists (especially capital gain/loss issue)

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Remedial Allocation Method

•If it does work we make it work

•Make correction and then create an offsetting items to return balance

•Or, to put it simply, plug it

•If use this method, for depreciation establish a new asset placed in service when asset is contributed (or there is a recapitalization)

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Revaluations

•Required in certain situations, allowed in others if agreement provides

•Creates “reverse” §704(c) allocations

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Distributions and §704(c)

•Can’t avoid the issue by pushing asset out to another partner

•For seven years, distributing property out to another partner triggers gain recognition

•“Could have been a §1031 Exchange” exception

•Watch for disguised sales rules as well

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For §737 have unique issue of worrying about fair value vs. basis for a distribution

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Making the Election

•Required attachments

•Late election relief under §301.9100-2(d)

•Revocation of Election

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Section 732(d) Election is Very Easy to Overlook

Partnership DistributionsBasis Issues for Partnerships and S Corporations

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Partnership Distributions

•Unlike corporations, generally no trigger of “deemed sale”

•Also, gain only recognized to extent of cash received

•But cash includes deemed cash from reduction in debt allocated

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Current Distributions

Reduce basis by cash (excess would

be gain)

Reduce basis for inventory/accounts

receivable basis

Reduce basis by basis of other

assets

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Liquidating Distributions

Reduce basis by cash (excess would be gain)

Reduce basis for inventory/accounts receivable basis (if

nothing else received, remaining basis is loss)

Allocate basis to other assets received

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Hot Assets

•Generally triggered if a distribution leads to a change in share of “hot assets”

•Hot assets•Unrealized receivables (note broader than

expected definition)•Appreciated inventory

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Regulations in Flux

Current regulations

• Gross value method

• Deemed distribution of proportionate share of hot/non-hot assets followed by a taxable exchange to get what was actually received

• Can create interesting situations if don’t just pay cash

Proposed regulations

• Before and after calculation for liquidation

• Look at any person whose• Share of hot asset income

goes down or• Share of hot asset loss

goes up

• Can elect to use, but must stay with if start using them

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Section 736 Distributions

•“Retirement” issue•Traditional liquidation payment is Section 736(b) payment•Payments in excess of capital treated as Section 736(a) payments•Ordinary income to recipient as guaranteed

payment•Special rule can exempt payment from self-

employment tax

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S Corporation DistributionsBasis Issues for Partnerships and S Corporations

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Taxation of a Distribution (Not a Dividend)

Return of capital up to basis in the stock

Capital gain for any amounts in excess of basis

Tax Dividends

•Different from state law corporate dividends•Treated as taxable income and do not affect basis•Generally a corporation will treat distributions as dividends up to the amount of earnings and profits•But S corporations interpose a special account known as the accumulated adjustments account

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Accumulated Adjustments Account

•Is a corporate (not shareholder) account

•Relevant only for•Treatment of S corporation distributions when

corporation has earnings and profits• In the post-termination transition period

•Generally impacted by same items as basis except for tax exempt income and deductions related to the same

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S Corporation Tiers

Accumulated Adjustments Account

• Treated as a distributions

• Recovery of basis, then gain

Earnings and Profits

• Taxable as a dividend (Form 1099DIV)

• No affect on basis

Distributions

• Back to recovery of basis

• Gain for exess

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Earnings and Profits

•Only created now in C corporation years

•Computed on year by year basis

•See worksheet on Form 5452

•Also have AICPA Corporations and Shareholders Tax Resource Panel practice guide

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Distribution Elections

•Bypass AAA

•Deemed distribution from E&P

•Election to bypass PTI (extremely rare now-only comes from pre-1982 earnings with pre-1982 shareholder)

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Post Termination Transition Period

•One year after ceases to be S corporation

•120 days from end of audit that changes S item

•120 days from determination S status has been terminated

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Sale of Interests/Net Investement Income TaxBasis Issues for Partnerships and S Corporations

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S Corporation Dispositions and Failures

•Worthless security rule

•Bad debt deduction issue

•Section 1244 stock

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Partnership Interest Sale or Exchange

•Determination of gain or loss

•Character of gain or loss

•Hot asset rules come back – with required reporting

•Potential for split holding period

•Installment sale of partnership interest

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Gift of a Partnership Interest

•Partnership interest with liabilities

•Assignment of income issues

•Family partnership issues

•Charitable contributions

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Abandonment

•1990 Revenue Ruling – can only get ordinary loss if there is no debt

•Otherwise a capital loss

•Still an issue on how Section 1234A affects this•Tax Court says effectively can never abandon•But Fifth Circuit overturned

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Net Investment Income Tax

•General rules for partnerships

•General rules for S corporations

•Key issue is if the entity carries on a trade or business in which equity holder participates

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1411 Reporting

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